Journal Entry for Software Purchase
Overview
In business, the company may need to purchase the computer software to use in order to improve its day-to-day business operation as well as other areas of operation such as finance and human resource management. In this case, the company can make the journal entry for the software purchase that is intended to be used internally by recognize and record it the same way as the fixed asset.
In accounting, the software that is purchased for internal use needs to be capitalized as an intangible asset and amortized over its useful life. Likewise, the company will also need to make the journal entry for the amortization of the purchased software at the period end adjusting entry in order to spread the cost of the software over its useful life. This is the concept of the matching principle of accounting which the company needs to match the expenses to the revenues or the benefits it receives from using the software over the accounting periods.
In the capitalization of the software purchased, the company should not include or add the costs related to the bug fixed or maintenance into the cost of the software on the balance sheet. The costs related to bug fixed or maintenance should be recorded as expenses on the income statement in the period it occurs.
Similar to the property, plant, and equity, only costs that can improve the life, capacity, or features of the software should be added to the cost of software on the balance sheet. For example, after one year of use of its cash management software, the company decide to pay additional costs to the vendor of the software to add the features of account receivable and accounts payable management into the software. In this case, such additional costs can be capitalized and added to the original cost of the software as the capacity of the software has improved as a result with new features of accounts receivable and accounts payable management.
Journal entry for software purchase
The company can make the journal entry for software purchase for internal use by debiting the cost of the software into the computer software account which is an intangible asset and crediting the cash account.
| Account | Debit | Credit |
|---|---|---|
| Computer software | 000 | |
| Cash | 000 |
In this journal entry, the computer software is an intangible asset on the balance sheet in which it needs to be recognized and recorded at cost and amortized over its useful life.
Likewise, at the period end adjusting entry, the company needs to make the journal entry for the amortization of the software purchased by debiting the amortization expense account and crediting the accumulated amortization account.
| Account | Debit | Credit |
|---|---|---|
| Amortization expense | 000 | |
| Accumulated amortization | 000 |
Accumulated amortization is a contra account to the intangible assets on the balance sheet which in this case is the computer software. Likewise, the normal balance of the accumulated amortization account is on the credit side.
As the purchased software is for internal use, it is important that the company properly amortize the software at each period end adjusting entry in order to spread its cost over its useful life to comply with the matching principle of accounting.
The company can amortize the purchased software cost by dividing it by the software’s useful life. For example, if the company estimates that a $20,000 software that can help improve the process of payroll will be used for 5 years, it can determine the annual amortization expense to be $4,000 ($20,000 / 5years).
Software purchase example
For example, on January 1, the company ABC purchases software for $30,000 for internal use as the software can help the company to effectively improve cash management together with the management of the accounts payable and accounts receivable. The company ABC estimates that the software will be used for 8 years based on the growth of its business. And it closes its year-end account on December 31.
In this case, the company ABC can make the journal entry for software purchase by debiting the $30,000 into the computer software account and crediting the same amount into the cash account on January 1, as below:
| Account | Debit | Credit |
|---|---|---|
| Computer software | 30,000 | |
| Cash | 30,000 |
In this journal entry, there is no impact on the total assets of the balance sheet as the computer software and cash are both assets, in which one asset (computer software) increases while another asset (cash) decreases resulting in zero impact to the total assets.
Later, at the period end adjusting entry of December 31, the company ABC can make the journal entry for amortization of the purchased software as below:
| Account | Debit | Credit |
|---|---|---|
| Amortization expense | 3,750 | |
| Accumulated amortization | 3,750 |
The $3,750 of the debit of amortization expense comes from the purchasing cost of the software which is $30,000 dividing by its useful life of 8 years ($30,000 / 8 years).